An updated view of fiduciary responsibility must incorporate the risks and value associated with sustainability for investment decision-making
Investment advisors function under a blanket of fiduciary obligations. These require them to undertake the duty of loyalty which includes acting in good faith and avoiding conflicts of interest, and observing prudence when it comes to the conduct of due diligence and protecting the interests of investors. The decisions made by investors ultimately trickle down the investment chain and affect the way companies are managed and operated.
Empirical and academic evidence suggests that sustainability issues are financially material and can generate investment value. Hence, analysis of sustainable components can aid investors in identifying the material issues in investment decision-making. The ignorance of sustainability issues in investment analysis could lead to mispricing of securities and poor investment decisions— effectively, a failure of fiduciary duty.
Sustainability is a systemic issue that could significantly alter securities pricing in some sectors, industries, and geographies. It follows that the incorporation of sustainability issues is a core characteristic of a prudent investment process. As policies and regulations around sustainability change around the world, the investment value of companies to accentate sustainability will also likely change to keep step. A report, “Fiduciary Duty in the 21st Century”, by the Principle of Responsible Investment (PRI) and United Nations Environment Programme Finance Initiative (UNEP FI), demonstrates the critical importance of incorporating ESG standards into the regulatory array of fiduciary duty. The report suggests that “failure to consider all long-term investment value drivers, including ESG issues, is a failure of fiduciary duty.” Financial regulators should clarify for asset managers such as pension funds, insurance companies, and mutual funds in the appropriate directives that sustainability must be incorporated in the investment decision-making process to ensure that their fiduciary duty is respected. This is a glaring gap in India, where sustainability is not emphasized as a significant factor in the fiduciary norm for investors and asset managers.
Financial regulators, such as SEBI, PFRDA, and IRDA, are yet to make clear in the directives to investors and asset managers to incorporate financially material sustainability issues in-stock selection, risk management, and asset allocation. Besides, the directives must make it mandatory for asset managers and fund managers to disclose and report the steps taken by investors and asset managers concerning sustainability in their fiduciary duty
Employ stewardship and active ownership
Another key component of stewardship is engagementor active ownership practices of investors and asset managers. Stewardship or active ownership is a concept that encourages investors and asset managers to play an active role in investment decision-making, including directly and indirectly influencing corporates to make certain business decisions to enhance the value of their investment. Stewardship or active ownership is a becoming an important part of these investor fiduciary duties, and in addressing sustainability risks in the portfolio.
The financial industry, particularly asset managers and institutional investors, use various active ownership tactics to influence corporates to identify sustainability issues and incorporate them in business decision-making. For example, oil and gas giant Shell recently committed to taking significant additional action on climate change, including a commitment to achieve net-zero emissions as a result of active engagement from investors led by the Church of England Pension Board and Robeco among others. Globally, asset management companies and institutional investors are widely deploying active ownership as a tool to exert pressure on the corporates to take necessary actions to reduce carbon emissions. Active engagement by institutional investors can include management of risks concerning sustainability and disclose their engagement reports to beneficiaries on the same.
The Financial Stability and Development Council (FSDC) is an apex institutional body set up to strengthen the mechanisms for maintaining financial stability, financial sector development, and inter-regulatory coordination in India. In 2018, The FSDC approved a common stewardship code in consultation with the SEBI, IRDA, and PFRDA. The stewardship code includes engagement with corporates on governance matters, issues related to poor financial performance, leadership, and any other risks. In addition, the codes warrant investors to exercise independent judgment in proxy voting and disclose stewardship practices. The code provides guidelines for the institutional investors to formulate a comprehensive policy detailing the monitoring and reporting mechanisms.
Although the SEBI Stewardship Code has ESG compliance norms, it does not have the wherewithal to force investors to follow the norms in spirit – there is no penalty prescribed in case of non-compliance. South African Stewardship Code considers ESG norms as a law under their Pension Funds Act, 1956, while Hongkong Code has emphasized the adoption of ESG norms in its Stewardship Code. These two countries have made non-compliance with ESG norms is punishable for investors. The Indian financial regulators can make sustainability norms strict and enforceable instead of just a passing reference.
Investors can implement stewardship in various approaches to influence investee companies. These include: engaging with corporates to support and encourage them to transition the businesses to less carbon-intensive and less pollutive; raising questions about sustainability issues in the Annual General Meeting (AGM); making sustainability issues a board agenda when exercising direct control over corporates.
Labanya is a Regional Climate Finance Advisor – Indo-Pacific, Commonwealth Secretariat, and Rajashree is an Analyst at Climate Policy Initiative. The opinions are personal.